Wealth Management: It’s All About Economies Of Scale

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By Greg Peel

An Australian federal government review is currently underway in the wealth management industry, with new regulations expected shortly. Like all such reviews it is reactive rather than proactive, and yet another “shut the gate” response to the Global Financial Crisis. It is, however, long overdue.

What the government is specifically targeting is the paying of commissions by fund managers to financial advisors. Australia’s comparatively healthy economy is one reason why wealth management is important in this country, but the overriding factor is compulsory superannuation. Individuals may choose to invest via a managed fund for any number of reasons – from short-term gain to children’s education investment to self-managed super – but for the great majority of Australians fund management investment is forced upon them by the compulsory super rules. This is the “forced savings” Paul Keating introduced to offset the eventual cost of an aging baby-boom population. And for the average Australian, ignorant of and inexperienced in financial markets, financial planners are the obvious helping hands.

Because of Australia’s relatively enormous super industry, there exists a huge number of management funds to choose from and a huge number of financial planners to help make that decision. Competition is fierce. In order to succeed at funds management, it helps to have “clout”, or, less colloquially, “scale”. The greater the value of funds under management, the more a fund can dictate to the market. This is particularly true for the vast amount of money invested in “passive” funds – those which simply maintain a balance of stocks, bonds and cash regardless of market movements. For these funds, returns are irrelevant. What is relevant is size.

Financial planners should, in theory, be independent specialists, able to apply due diligence to choose amongst the vast array of funds on offer and tailor investment to the specific needs of the individual investor. That is the perfect world scenario. In the real world, however, managed funds provide incentives to financial planners to encourage their clients to invest only in that fund manager’s products. For their trouble, the financial planners receive “trailing” commissions.

Managed funds underwent a shake-up after the 2002-03 recession, in which retirees discovered that ongoing management fees had eroded a great deal what super they had amassed over their working lives, such that little return was provided on top of the total of incremental payments once inflation had done its bit. Suddenly the race was on in the industry to either reduce or even completely eliminate management fees in order to stave off dissatisfaction from investors and the growth of self-managed super. One way to do this was to rely only on performance fees, but these were no good for passive funds. To overcome the loss of overt fees, managed funds instead took to covert fees. Investors thought they were investing in a low-fee fund but instead their returns were now being eroded by ongoing trailing commissions paid to the financial planners who “select” which fund should be invested in.

Investors were now being screwed covertly, rather than overtly.

There has long been concern with regard to a medical industry in which doctors are encouraged to prescribe certain drugs, perhaps unnecessarily, via various hard or soft dollar incentives. The same is true, analogously, in funds management. Financial planners are encouraged to “prescribe” investments which offer the best incentive to the financial planner, not the investor. And the more a financial planner can move an investor’s funds around, the more trailing commissions can be achieved. Little regard is given to what actual returns might be forthcoming.

This is what the Australian government is looking to fix, and as such there is currently a pall of uncertainty hanging over those larger demutualised, listed wealth management “companies”. Two of the biggest in this country are the old Australian Mutual Provident, now AMP Ltd ((AMP)), and AXA Asia-Pacific ((AXA)), a partly-owned subsidiary of French-based parent AXA SA.

(According to the AXA website, the word “AXA” is meaningless, despite being capitalised as if it were an acronym. It is just a name that can be pronounced the same in all languages, and which starts with a “A” to put it near the top of any list.)

Under normal circumstances, the Australian government and its independent authority, the Australian Competition and Consumer Commission (ACCC), encourage competition within an industry and attempt to prevent concentration or dominance (don’t get me started – we’ll just assume that’s the idea). In the case of the wealth management industry however, the government has indicated ahead of its review that it would rather see a smaller field of players with greater scale, rather than the current vast array of players competing for the investor dollar indirectly by rewarding financial planners and not the investors themselves. In this case, too much competition has bred questionable industry practices bordering on fraud.

On this basis, the ACCC is already in a position to feign ambivalence about wealth management consolidation, even if two of the big players say AMP and AXA – were to merge.

Because there is an industry review underway – one which it is assumed will result in lower fees for fund managers, by hook or by crook – stock market investors have been fearful of investing in listed fund managers (ie investing in their shares as opposed to their funds. We won’t go into why demutualisation has a lot to answer for in the first place). This means shares in the likes of AMP, AXA and others. This is the pall of uncertainty.

Shares in listed fund managers had already been beaten down as a result of the GFC, which sparked a loss of equity market value and a withdrawal of wealth. But the subsequent stock market rally has meant a return of funds flow, albeit timid, and improved equity market values. This should have meant a solid bounce in listed fund manager valuations, but because of the “pall” the market has been reluctant. As a result, analysts have being suggesting for some time that the market is undervaluing AXA, for example, even taking worst-case fee restructuring possibilities into consideration.

Hence we have a sector ripe for merger and acquisition activity. The ACCC is no threat, and stocks are trading at a discount.

That is why yesterday AMP and AXA SA teamed up to make a cash and scrip offer for AXA Asia Pacific, the Australian-listed entity. The deal would see AXA SA take over the Asian operations of AXA Asia-Pacific for cash and AMP take over the Australian and New Zealand operations on the scrip-swap.

Analysts agree on two points: (1) it is a strategically sound deal for both parties; (2) the price is not enough.

This is not the first time AXA SA has attempted to buy out the balancing majority stake in AXA AP – it had a go in 2004 but was rejected by the AXA AP board. And nor is AXA AP going to go down without a fight this time around either, as the board immediately dismissed the combined offer. While an offer price equating to around $5.30 (the scrip component will cause this price to fluctuate) when AXA shares had been trading at $4.30 seems like a significant premium in a still uncertain market (23%), the fact that AXA has been trading at up to a 30% discount to analyst valuations due to the aforementioned “pall” means realistically the price is a bit on the low side. This was clearly the board’s view too.

But as Eric Idle would say, “you’ve got to haggle”. Rarely is an initial takeover offer also a final takeover offer – prospective buyers will usually test the water first unless they are greatly afraid of sparking a rival bid into action. So how much might AMP be actually willing to pay? And how might this affect the value of AMP’s own shares?

First one must consider why the AMP wants to take over AXA Australasia in the first place, and why analysts think its a good idea.

Credit Suisse, for one, suggests AXA offers AMP a greater distribution diversification, providing greater access brands, products and platforms to the “third party channel” (ie financial planners). There are also synergies to be gleaned, albeit at an integration cost, but more on that in a moment.

BA-Merrill Lynch, however, sees it slightly differently. “AXA seems to bring little to AMP in terms of brand, alternative distribution, product, intellectual property etc,” the analysts suggest, “that AMP does not already have or do better”.

But while these two views seem opposed, the conclusion is nevertheless the same. Says Credit Suisse, “We deem a combined AMP/AXA Australian and New Zealand operation a formidable business in the attractive funds management and life insurance markets”. CS notes AMP/AXA would be a market leader in both. Says Merrills, “We see this as a defensive transaction whose merits rest predominantly on scale and AMP’s capacity to cut head count, consolidate platforms and technology”.

All analysts agree, despite whether it is from an offensive or defensive prospective, that scale is what it’s all about. And no one is against the idea on face value. Scale is good in any market one wishes to dominate, and in this case scale is actually beneficial in the eyes of a regulation-primed government.

But the practice of taking over the opposition simply for the sake of taking out the competition, and being the biggest, is fraught with danger. AMP management has suggested there are $120m dollars of worth of synergies to be had but that the complex process of integrating the businesses – particularly life insurance – would cost $285m. This is one reason why “defensive” might be written all over this deal. Management has tried to suggest the deal is 1% earnings accretive in year one but this is the figure inclusive of synergies but exclusive of costs. Taking costs into consideration, analysts suggest year one will see 3% earnings dilution.

They do, however, tend to agree the $120m synergy figure is likely conservative, but also agree there is a risk integration will be more complex, and thus possibly more costly, than AMP is assuming. Nevertheless, all agree that in order to win the approval of the AXA AP board and the large percentage of retail shareholders the price – which is only slightly more on enterprise value terms than National Bank ((NAB)) paid for the Aviva wealth management business recently, will need to be sweetened. Analysts see definite benefits for both AXA AP and AXA SA in the split, but there’s no reason to simply give the business away on first offer.

Analysts are in general agreement the two bidding parties could pay up to a $6.00 cash/scrip value before the deal looks too expensive. The next consideration, however, is whether any other players might be sparked into entering the race.

The obvious contenders are the other big wealth managers in Australia – the Big Four banks. All have indicated their intentions to expand their wealth management exposure, all have increased their tier one capital bases (and to an extent to allow for acquisitions), and all have now begun to believe GFC-related bad debts will not be as extensive as previously feared, meaning overloaded provisions can be brought back into capital.

If any of the big four are interested, then they will have to move swiftly. None can afford to take over an already merged AMP/AXA, only AXA AP or, for that matter, AMP, individually. This deal has also in theory put AMP “in play” as well.

Commonwealth ((CBA)) only yesterday noted it had intentions in the wealth management space, but has ruled out a counterbid for AXA. ANZ Bank ((ANZ)) is using its money to buy up assets in Asia, so it makes little sense for ANZ to want to do the same deal as AMP. If anything, it would look to counter AXA SA’s bid for the Asian business, but that is unlikely. NAB has just bought Aviva. That leaves Westpac ((WBC)) as a possible contender, but Westpac still has the arduous task of St George integration on its plate and may find AXA or AMP a stretch.

In short, the Big Four don’t really look like obvious contenders. This does not rule out offshore interest (Blackrock has previously hinted at an interest in AMP), but for the moment analysts are assuming a higher, and probably winning, bid will be forthcoming from the AMP/AXA SA team.

Nothing new will happen overnight on that front, however. This is simply the beginning of what may yet prove a drawn out process. The market has taken AXA’s stock price up to $5.87 so far – way above the previous $4.30 share price but short of the $6.00 analysts feel could be offered. However, on announcement the offer equated to around $5.30 equivalent but the market has now also piled into AMP shares (after an initial wobble), meaning the equivalent bid is closer to $5.80.

In theory, analysts will now also have to lift their $6.00 takeover price targets to accommodate the increased value of AMP scrip in the offer.

In response to the deal’s announcement, Credit Suisse has upgraded its recommendation on AXA to Neutral from Underperform, being the only change in the FNArena database. That leaves a 2/8/0 Buy/Hold/Sell ratio on a new average target of $5.34 (up from $4.96), with UBS moving into restriction due to its advisory role.

There have been no changes to AMP’s 3/5/1 ratio so far, other than UBS again on restriction. AMP’s average target has ticked up from $6.85 to $6.90.

It’s game on in the wealth space.

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